Using Tax Brackets to Reduce Your Effective Tax Rate in 2021

Because tax season is just around the corner, many business owners and financial professionals have begun to turn their attention to lowering tax liabilities for themselves and their clients. One of the ways that can be done is by strategically using the brackets of the progressive tax system. At this point, you may be wondering how that works. Well, today’s entry is all about using tax brackets to lower your effective tax rate!

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TIME INDEX:

• 00:48 – How to Use Tax Brackets to Reduce Your Effective Tax Rate
• 01:47 – The Progressive Taxation System
• 05:51 – Why it Matters
• 07:35 – The Basics
• 09:26 – Example
• 10:31 – Summary

The Progressive Taxation System

Under this system, the more you earn, the more you will owe in taxes. However, if you find yourself in one of the higher tax brackets it doesn’t mean that you will pay that tax rate on your entire income.  Let’s assume that you earned $100,000 last year. This means that you would pay 10% of your income up to $9,875 (filing individually) or $988. Then you would pay 12% on your income from $9,876 to $40,125 which totals $3,630.

As you can see, our tax bracket system is essentially a hybrid of the flat tax and the progressive taxation system. Although there are flat rates for each tier, it’s likely that you will pay multiple “flat rates” as your income spans across multiple tiers. Therefore, portions of your income will be subject to progressive taxation. Every tax-paying American pays the same amount on their first $9,700 of income regardless of whether they make $50,000 or $50 million.

RELATED READING: How To Calculate Your Effective Tax Rate

Does It Matter?

Although there is only a small difference between the brackets, they can account for sizable savings on your effective tax rate. Using tax brackets to reduce your effective tax rate matters, folks. Here’s why… contributions for Roth IRAs phase out in 2020 at adjusted gross incomes (AGIs) of $196,000 to $206,000 for couples and $124,000 to $139,000 for singles ($193,000 to $203,000 and $122,000 to $137,000, respectively, for 2019).

Deduction phase-outs for traditional IRAs also start at higher levels in 2020, from AGIs of $104,000 to $124,000 for couples and $65,000 to $75,000 for single filers. This is up from $103,000 to $123,000 and $64,000 to $74,000 last year. However, if just one spouse is covered by a plan, the phase-out zone for deducting a contribution for the uncovered spouse starts at $196,000 of AGI and ends at $206,000, an increase over last year’s $193,000 and $203,000.

Capital Gains

In addition to the new phase-out numbers, the income thresholds to qualify for the various tax rates on long-term capital gains and qualified dividends. The 0% rate applies for individual taxpayers with taxable income up to $40,000 on single returns, $53,600 for head-of-household filers, and $80,000 for joint returns. Meanwhile, the 20% rate for 2020 begins at $441,451 for singles, $469,051 for heads of household, and $496,601 for couples filing jointly.

As a married couple filing jointly, if you make $86,000, you’re $6,000 above that 0% capital gains rate. If you’ve got large capital gains, that could be a huge sum of money that you’re forfeiting to taxes. So, the bracket matters. That’s why you want to reduce that tax bracket.

Putting It All in Action

Now that we understand that using tax brackets to reduce your effective tax rate is a legitimate strategy, how do we put it into practice? There are a variety of different ways, but I like to use my own “planner’s checklist.” My list isn’t exhaustive by any means. So, if you’re interested in learning more ways to lower your adjusted gross income to put you into a lower tax bracket, you may want to check out this post on reducing your taxable income.

For now, you can take the planner’s mindset by contributing to your HSA, 401(k), and traditional IRAs. Oftentimes, business owners will utilize profit sharing in order to lower their taxable income. In fact, profit sharing may even help you to qualify for Qualified Business Income Deductions (QBID) which is a 20% deduction. Likewise, you can use cash balance plans, pay certain expenses in advance, or even make equipment purchases. By reducing your AGIs you might be able to put yourself in a lower tax bracket. Thus, improving your effective tax rate.

Wrapping Up…

Friends, we’ve done it. We have reached the end of 2020 and we survived. Now we can turn our attention toward 2021 and make it the best that it can be. Life is hard, but life is so good! Using tax brackets to lower your effective tax rate can be frustrating. But it doesn’t need to be. Knowing how the brackets work and applying various strategies to your finances can make lowering your effective tax rate at least financially simple.

If you need more information or require a more specialized approach to lowering your taxable income, reach out to us. The team at Financially Simple has helped hundreds of business owners just like you,